Iron Butterfly explained
The iron butterfly spread is a neutral strategy that is a combination of a bull put spread and a bear call spread. It is a limited risk, limited profit trading strategy that is structured for a larger probability of earning smaller limited profit when the underlying stock is perceived to have a low volatility.
To setup an iron butterfly, the options trader buys a lower strike out-of-the-money put, sells a middle strike at-the-money put, sells a middle strike at-the-money call and buys another higher strike out-of-the-money call. This results in a net credit to put on the trade.
Limited Profit
Maximum profit is attained when the underlying stock price at expiration is equal to the strike price at which the call and put options are sold. At this price, all the options expire worthless and the options trader gets to keep the entire net credit received when entering the trade as profit.
Limited Risk
Maximum loss is also limited but significantly higher than the maximum profit. It occurs when the stock price falls at or below the lower strike of the put purchased or rise above or equal to the higher strike of the call purchased. In either situation, maximum loss is equal to the difference in strike between the calls (or puts) minus the net credit received when entering the trade.
Example
Suppose XYZ stock is trading at $40 in June. An options trader executes an iron butterfly by buying a JUL 30 put for $50, writing a JUL 40 put for $300, writing another JUL 40 call for $300 and buying another JUL 50 call for $50. The net credit received when entering the trade is $500, which is also his maximum possible profit.
On expiration in July, XYZ stock is still trading at $40. All the 4 options expire worthless and the options trader gets to keep the entire credit received as profit. This is also his maximum possible profit.
If XYZ stock is instead trading at $30 on expiration, all the options except the JUL 40 put sold expire worthless. The JUL 40 put will have an intrinsic value of $1000. This option has to be bought back to exit the trade. Thus, subtracting his initial $500 credit received, the options trader suffers his maximum possible loss of $500. This maximum loss situation also occurs if the stock price had gone up to $50 or beyond instead.
To further see why $500 is the maximum possible loss, lets examine what happens when the stock price falls below $30 to $25 on expiration. At this price, only the JUL 30 put and the JUL 40 put options expire in-the-money. The long JUL 30 put has an intrinsic value of $500 while the short JUL 40 put is worth $1500. Selling the long put for $500, and factoring in the intial credit of $500 received, he still need to fork out another $500 to buy back the short put worth $1500. Thus his maximum loss is still $500.
Commissions
It is important to note that commission charges weigh heavily in an iron butterfly trade. This is because there are 4 legs involved in this trade compared to the simpler options strategies like the long call or vertical spreads which only involve 1 or 2 legs. To reduce the impact of commissions on profits, one may wish to trade options that expire in 2 to 3 months instead of trading the near month options.
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Related posts:
- Iron Condor explained
- Butterfly Spread explained
- The Butterfly vs. the Broken Wing Butterfly
- Understanding Options – Profit (loss) vs Price Graphs
- Stormy Nov Trade
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